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The third estimate of Q2 2004 US economic growth was a pleasant surprise. The economy grew 3.3% per annum, revised up from only 2.8% in the previous estimate a month ago. The improvement was attributed to a less bad trade deficit and greater inventory accumulation. The easiest way to grasp what is generating economic growth is to look at the contribution to growth from the main sectors of the economy. Here are the figures and what they imply:

CONTRIBUTION TO REAL GDP GROWTH

The GDP figures confirmed that the US economy is part of the way through a useful transition: to investment-led from consumption-led growth. Business capital spending had been depressed for several years after the collapse of the high-tech bubble. But that began to change last year, as business financial positions improved, investment incentives in the Bush tax cut program took effect, and companies sought to upgrade their computer systems. By the second quarter, business equipment and software expenditures accounted for almost a third of total growth. The share of consumption, by contrast, declined significantly. Personal outlays had bulged between 2002 and early 2004, as consumers took advantage of higher incomes, lower taxes, and the proceeds of massive mortgage refinancing. Those factors are now subsiding. However, the latest data on personal consumption expenditures for the third quarter  an upward revision for July and stable spending in August, despite a plunge in auto sales and two hurricanes  imply growth of at least 4% per annum in the third quarter. The US consumer is still happily spending, notwithstanding somewhat more restrained consumer sentiment surveys lately.

What hasnt yet started a transition is homebuilding and the foreign trade sector. The strong contribution of residential construction to GDP growth is only just now beginning to fade. However, activity in the housing market as whole will stay robust as long as interest rates remain at such low levels. Long-term mortgage rates are lower today than two years ago, when the economy was far weaker. Accordingly, existing home sales are running at a record level of close to 7 million units per annum.

As for the trade deficit, it is still rising. Net imports subtracted about a full percentage point from growth in Q2 2004, a little less than previously estimated, but still very substantial. The US consumers and businesses spend more than they collectively produce, but foreign central banks are stifling exchange rate changes that might help adjust the imbalance.

CORPORATE PROFITS BY INDUSTRY GROUP

CHANGE FROM PRIOR PERIOD SAAR, $ BILLIONS

The biggest casualties of the trade imbalance are among those US industries that face the most intense pressures from foreign competitors. They are found in the computer and electronics industry, the electrical equipment and appliances industry, and the motor vehicle sector. These industries continued to record substantial losses. Elsewhere in the economy, operating profits rose in most industries, apart from retailing and utilities.

INDUSTRIES WITH PERSISTING LOSSES,

LEVEL SAAR, $ BILLIONS

At the level of the individual corporation, operating earnings are not the whole story. What matters for shareholders are changes in the net worth of a company. According to the latest Federal Reserve Flow of Funds Accounts, the net worth of US nonfarm nonfinancial corporate business, measured at market value, went up by an impressive $438.4 billion during the first half of 2004  to $10.4 trillion. Most of that is attributable to the strong pick-up of capital expenditures. But corporations were also able to increase their net financial assets by about $80 billion. So they became more liquid. Holding gains on real estate went up by $80 billion, too, reflecting an improvement in the values of commercial buildings such as offices, shopping centers, and factories.

These figures have not served to strengthen confidence in the US stock market, however. Stock prices are historically very low relative to US Treasury yields, almost three standard deviations below the average relationship. Price-earnings ratios are down to levels last seen back in 1997. Forecasts of economic growth in the 3%-4% range for 2005 have been greeted by stock market participants with a big yawn. Until it becomes more likely that companies can achieve the kind of growth rates in profits that were attained in 2002 and 2003, either through greater sales volumes or improved pricing power, the stock market will continue to struggle  at least through election day!

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